Investors looking to use structured products to access the commodities markets have been forced to learn some harsh lessons in the crisis, as have the private bankers that sold them the products in the first place. Writer Charlie Corbett
Something of a paradox lies at the heart of investment in commodities. While commodities have the potential for enormous long-term growth, in the short term investors can be exposed to massive volatility. One only has to look at the price of oil between October 2008 and early 2009, which fell from highs of more than $140 a barrel to as low as $45 a barrel, to appreciate the truly gargantuan potential swings in fortune.
Despite these potential pitfalls, private investors are turning to investment in commodities in their droves. According to Barclays Capital, total commodity-linked assets under management grew 36% in 2009 to $257bn. Commodities have become a fully fledged asset class in their own right. Many see commodities as a sound diversification play, which has the potential to generate strong, uncorrelated returns to traditional markets. For many investors, it is also the safest way to get access to the emerging markets growth story.
In the words of George Lo, the former chief investment officer of Lloyds TSB International Private Banking: "Brazilians, Chinese and Indians want to live like Americans now." This is having a profound impact on the supply of and demand for most basic commodities. As the inhabitants of emerging economies such as these become increasingly consumer driven and as their diets change from largely non-meat to meat-based products, the demand for both food and energy-based commodities will soar.
A slice of the action
The big question in most investors' minds is how to get exposure to the predicted longer-term upward trend in commodities prices, without necessarily being exposed to shorter-term volatility. It is incredibly hard for a private investor to trade directly in commodities. Just to put that in perspective, the smallest tradable contract size of copper was, until recently, $170,000, while for Brent crude oil the smallest contract available is for 1000 barrels, or in 2008's prices, $140,000. Such prices rule out the average high-net-worth investor in terms of direct investment in commodities.
Instead, there is a range of alternative options available for those investors looking to link their fortunes to the commodities story. Until recently, the most popular way to gain exposure was through the purchase of structured products. The idea was to structure an instrument that linked investment to an underlying individual commodity, or basket of commodities. In some cases the investor's capital would also be protected in case of a dramatic downswing in prices. Typically held for five years, such products aimed to give the relevant exposure to the upside in the commodity story, while protecting them from any downside risk. As with all investment fads, however, the temptation was to take ever more risks and create ever more complex instruments. What had started out as a way of protecting investors' capital, in fact left them severely exposed when and if markets came crashing down. And then Lehman Brothers went bankrupt...
New world order
Lehman's bankruptcy and the subsequent panic in financial markets was a disaster, not only for the underlying commodities prices, but for those that held their exposures in structured as well as structured index-linked notes. Not only did the underlying investment collapse in value, but those investors that wanted to close their positions and sell up found there was no market in which to sell the product. Mark-to-market valuation techniques meant their investments had essentially become worthless. "Large moves in the underlying [asset] can leave you with an unappealing result. If there is a liquidity event in your life or for whatever reason you feel you don't want exposure anymore, trying to shift the thing is very, very painful in terms of realised loss," says Johannes Jooste, a portfolio strategist for Merrill Lynch Wealth Management, based in London.
This has had a profound effect on investor attitudes towards structured products and the way in which financial intermediaries market them. Mr Jooste says that the market is "vastly different" today than it was two years ago. In particular, investors have learnt the hard way that the credit quality of the investment banks that supplied the products in the first place could not necessarily be relied on. In this environment, so-called 'capital guarantees' became meaningless. "You can't call it a 'capital guarantee' anymore because nobody is above the possibility of default so you have to call it principal protection. Assuming the underwriter doesn't go bust, you can get your money back," says Mr Jooste. "The way [structured products] are marketed now has got to change. The industry needs to be far more clear [to investors] that mark to market can be a very different thing to the final day pay-off."
Keep it simple
What worries investors the most about gaining exposure to commodities through structured products is their complexity. Arguably, the single biggest catalyst for the financial crisis was a profound lack of understanding among the investment community of the products they were involved with. This has led to a number of changes in today's market. Simplicity and transparency are now the watchwords. "You don't want too many complex schemes," says Paul Sarosy, a managing director of Credit Suisse in the private banking division, based in London. "You want something simple and understandable with terms that are easy to understand." Another private banker, who wishes not to be named, says there has been a reversal in the way in which investment banks and private bankers do business.
"We on the private banking side are the ones testing the market and client needs. We then take that information to the investment banks and look to develop a product using our criteria," he says. This is a break from the past, when investment banks constructed the products and simply shifted them onto private bankers to distribute among their clients, no questions asked. "We're actually the originator [of the product] now and we are using our investment bank to build it," the private banker says. "I feel a lot more confident this way, looking an investor in the eye and saying: 'this is how we're doing our business', rather than an investment banker pushing something at us and then us going and distributing it."
Nicolas Cagi-Nicolau, global head of structured product solutions at Société Générale Private Banking, says that private bankers have become very careful now in the way in which products are structured and in their selection of the assets that go into them. "The key for us is to make sure that all our processes are fully transparent and the selection of the underlying assets is linked to a rational and macroeconomic analysis," he says. Société Générale Private Banking has implemented rigorous set of 234 criteria for investment banks' products to meet, before the bank selects an issuer. Once a universe of authorised issuers of structured products has been drawn up, they are then subject to further scrutiny on a quarterly basis.
"Banks have cottoned on to the fact that it doesn't really pay in the long term to saddle investors with risks they do not understand," says Mr Jooste. "If it goes wrong once, you've burnt a relationship and in private banking that is what it's all about. The industry is adapting to these requirements." In particular, it is simplicity that wins out over complexity these days. "The way banks and investors understand underlying risk now has changed," says Mr Jooste. "In terms of liquidity, as you add layers of complexity you strip away potential liquidity. It makes it harder to price. It makes less people in the market willing to price it and it basically makes the cost of exiting more and more."
Long-term potential
Looking ahead, after a severe trough in late 2008 and through the course of 2009, issuance for structured products linked to commodities is gradually on the up once again. According to Barclays Capital, issuance in April 2010 was at $718m, up by just over $100m year on year. Commodity index-linked structured notes remained the most popular form of investment. The steady rise in issuance, however, is happening amid a backdrop of severe caution.
"People are much more careful and astute in terms of what they are buying," says Mr Sarosy. "Transparency, openness and clarity of what you are buying is essential in today's market - especially in the private client arena."
In terms of the underlying commodities markets themselves, despite some short-term volatility linked to fears over global contagion from the Greek debt crisis, the long-term prospects are good. A voracious China and emerging middle classes in India and Brazil guarantee that demand is set to remain high in the future. The one difficulty investors will have, however, is in when they choose to enter the market. According to Mr Lo, all the good news is already priced into the commodity markets, leaving prices high and room only for a downswing.
However, a fall in prices in the short term is a perfect buying opportunity. "If Greece caused the economy to go into a double-dip recession, commodities will correct dramatically," says Mr Lo. "If that happened that would be a very good opportunity to buy. Longer term, however, there is limited upside. Too much good news is priced in already."
When it comes to how investors get their exposure to such commodities, Mr Jooste sums up the new attitude among private bankers towards structured products: "Simplicity wins over complexity in today's world and more transparency is better than less". Mr Sarosy agrees. "After 30 years as a private banker, I would say the basics still prevail: having a true understanding of what you're buying, having an open dialogue about the risks associated, and proper diversification.
"It's OK to get a 7% to 9% return and have reasonable risk than chase 12% and 15% returns and not know what risk you're taking. It's about transparency and understanding risk."
